Reducing Wealth Inequality Requires Holding Risky Assets

How do people build wealth? How do low-wealth families climb the economic ladder? It’s simple. They save. They get decent or even above-average returns on their savings. And they reinvest those returns over time. Unless policymakers and advocates face up to these simple propositions, policy efforts to reduce wealth inequality will go for naught.

Over many years I have had the privilege of working with groups concerned with wealth inequality and promoting asset growth. One of them, the Corporation for Enterprise Development, has been holding its biennial Assets Learning Conference, engaging over one thousand professionals. I cofounded and work with the Urban Institute’s Opportunity and Ownership initiative, which researches wealth inequality. Because of their concern for the well-being of low-income, low-wealth households, these engaged individuals often try to figure out ways that government can simultaneously support and protect more vulnerable populations. One consequence, though, is a hope and sometimes belief that asset-building policies can increase wealth without reducing consumption and can generate higher returns without requiring risk taking.

But saving by definition means forgoing consumption. Even if government provides the money, it forces individuals to save rather than immediately spend that money.

This fact creates a controversy among progressive advocates. A dollar spent on wealth building means a dollar not spent on food, health care, or other transfers for immediate needs.

Finance 101 further teaches that higher returns on saving come from investment in riskier assets. The expected return on stock is higher than the return on bonds, and the expected return on bonds is higher than the return on savings accounts and Treasury bills. Over several decades the after-inflation investment return on corporate stock has averaged close to 6 percent, whereas the return on five-year government bonds sits at around 2 percent. The expected return on many saving and checking accounts is close to zero. Compounded over time, average stock market investors will see their money multiply about eight times after 36 years; average medium-term bond investors will see theirs double. Savers using only checking and saving accounts, meanwhile, will see little if any growth.

Over short periods, however, stocks have the highest risk of the assets just mentioned, while savings accounts have the least. Over very long periods, the risks reverse. Investing in the stock market is like flipping a coin bent enough that betting on heads on average nets a good return, but there’s a high probability of a loss with a few flips. As the number of flips increase, the odds of having more heads than tails get better and better. John Bogle, founder of Vanguard, said it like this: “The data make clear that, if risk is the chance of failing to earn a real return over the long term, bonds have carried a higher risk than stock.”

It’s possible to buy stock and insure against losses relative to, say, a short-term bond. But the insurance will cost the difference in returns plus additional transactions costs. Thus, attempts to provide low- and moderate-wealth households both higher returns and low risk tend to fail.

Just look at the household assets reported on wealth surveys. Wealthy households hold the vast majority of their wealth in stock and small business assets and real estate either directly or through retirement accounts. They make much of their money not just by saving more initially, but by allowing the saving on higher-return assets to compound. Low-wealth households, meanwhile, own few or no high-return assets, tend to hold more debt relative to their incomes, and often pay higher interest on that debt.

Timing matters, too, especially when it comes to large, infrequent purchases like buying a home. Mortgages became widely available to lower-income households in the early 2000s, when home prices were at a peak, but less available after the Great Recession, when prices were lower and owners were getting capital gains in many regions. As Bob Lerman, Sisi Zhang, and I have pointed out, this created a “buy-high, sell-low” mortgage policy that devastates low-wealth households, including the young.

The policy implications are clear. Simply taxing the rich more or distributing more to low-wealth households will do little to narrow wealth inequality. Transfer programs rarely encourage wealth-holding and may even exacerbate private wealth inequality by imposing asset tests and by favoring renting over homeownership.

None of this means that the rich shouldn’t pay higher taxes or that transfer programs don’t protect vulnerable families or even provide a type of “asset” in the form of income and risk protection. That’s another subject. The subject here is the distribution of private wealth and the power it brings.

Advocates and lawmakers trying to counter wealth inequality, therefore, must find ways to get low-wealth savers into longer-term assets like stock and real estate, mainly through retirement plans and homeownership. Small business ownership also matters. And, subsidies provided by government must encourage long holding periods—that is, saving over time, not short-term deposits. Deposits followed quickly by withdrawals or loans don’t increase saving. Nor do proposals that subsidize borrowing encourage homeownership, since, by encouraging more borrowing, they often reduce net home equity.

Of course, many low-wealth households are not ideal investors in riskier assets. But there are risks and there are risks. Remember that Social Security and Medicare—and, to some extent, traditional pension plans—already require nonelderly adults, whatever their other needs, to “save” some income today to prevent inadequate income in old age.

Successful investment requires forgoing consumption, taking risks, and adopting a long-term view. Those attempting to address wealth inequality must either recognize these fundamental facts—and the related costs involved—or fail in their mission.

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Great piece, Gene. As you know, I favor a universal retirement savings system for the U.S., similar to those in Great Britain and Australia. Because low-wealth individuals have good reason to be more risk-averse than the more wealthier (they may need their money for survival), it’s necessary to have fiduciaries assist them in making long-term or retirement investments. One way 401(k)s are dealing with this now is offering employees target-date funds in which risk diminishes as they age.

Professor Steuerle,
I could not agree with you more in the proposition that savings leads to the opportunity to invest, and that risky assets produce higher returns over time. That at least is what the past 5000 years of economic history has shown us. However, the financial repression being wrought on all economies now with the single mindedness of “stimulating consumption and hence, growth” is generating a larger chasm between the wealthy and the non-wealthy than ever before. Your statement, “Compounded over time, average stock market investors will see their money multiply about eight times after 36 years; average medium-term bond investors will see theirs double. Savers using only checking and saving accounts, meanwhile, will see little if any growth.” may NOT be applicable now. I see monetary policies destroying the price discovery function of public markets, and simultaneously, forcing savers to pay for the widening divide of wealth. I see prices that imply much lower rates of return on risky assets moving forward than past long-term averages. I see conditions in markets that we have not seen in the 5000 years of economic history that have generated those long-term average returns. I think Mr. Bogle was in the right place at the right time in his heading of Vanguard, but would opine that today’s artificially inflated real and financial assets make for a poor risk/return proposition to assume the long term trend will continue from this level. I pray that our policy makers begin to realize the folly of this grand experiment. They have exacerbated the very problems that they attempt to fix.
Thank you for your thoughts and blog posts, they bring about great discussions.

I absolutely agree – which is why I favor diverting a portion of an equalized Social Security Employer Contribution to ownership (and an eventual controlling interest) of the workplace of the employer. Then the risk his hedged – both by investing some of these funds in an insurance fund to make sure employee-owners have some reserve if their company goes belly up – and by the efforts of the employees themselves to succeed. If enough firms do that, the capitalists will eventually have green paper and no control.

[…] C. Eugene Steuerle, at the Urban Institute, believes low- and moderate-income people have to build wealth by saving and investing in stock and then reinvesting. By repeating this process over a long period, stock investors will see their money grow eight times over 36 years, as compared with the two times appreciation they have investing in bonds, if past patterns hold. Furthermore, Steuerle suggests that making long-term investments makes sense since, as time goes by, stock investments are less risky than bond investments. Yes, I know this seems counterintuitive, but the evidence is clear. […]

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The Government We Deserve is a periodic column on public policy by Eugene Steuerle, an Institute fellow and the Richard B. Fisher Chair at the nonpartisan Urban Institute. Steuerle is also a former deputy assistant secretary of the Treasury. The opinions are those of the author and do not necessarily reflect those of the Urban Institute, its trustees, or its sponsors.
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